Basic Concepts and Instruments of Fiscal and Monetary Policy

The ways, specific objectives and instruments for implementing the above functions are defined by the economic policy of the government.

Economic policy comprises of the views and approaches, decisions and actions the government applies to intervene into the national economy to attain its political and socio-economic objectives. Economic policy defines the goals of the government and the instruments to to attain them. Its general goal is the enhancement of the economic well-being

of the country, and this general objective is divided into specific objectives to be directly implemented. These specific objectives are: to maintain economic stability (including the stability of price level, employment, and balance of payments), to enhance economic growth, to support the structural reorganisation of the economy, and to influence the redistribution of incomes.

The above objectives are not independent, and a move into the direction of one often makes the other more difficult to attain. Therefore economic policy has to be very careful in avoiding conflicting objectives, and this may necessitate the ranking of particular objectives by their importance. Growth-oriented economic policy gives the priority to objectives enhancing economic growth, while anti-inflationary economic policy prefers measures and actions that slow down the increase of prices (Misz-Tömpe, 2006).

The typical instruments of attaining policy objectives are categorised as below:

Demand side instruments: instruments of economic policy that affect aggregate demand, affecting either the goods market (the position of the IS curve) or the money market (the position of the LM curve).

Supply side instruments: policy instruments affecting the total output of the economy, i.e. aggregate supply, therefore they may affect the labour market (by payroll taxes and other labour-related measures), or the macroeconomic production function (by taxes and subsidies influencing factor prices and technological developments).

Monetary policy is a demand side policy influencing the money market (i.e the position of the LM curve). Monetary policy affects the quantity of money in circulation, by controlling the interest rates, the reserve ratio or the foreign exchange rate.

Fiscal policy deals with the government budget, that is, the government revenues (taxes) and the government spending (goverment expenditures and transfers). Fiscal policy instruments include supply side instruments and demand side instruments affecting the goods market (the IS curve) (Meyer-Solt, 1997; Misz-Tömpe, 2006). These approaches are summarised in Figure 11.1.

Figure 11.1: Economic Policy Approaches

Source: Author’s own construction by Meyer-Solt (1997).

Both fiscal and monetary policy may be expansionary and contractionary. The purpose of expansionary fiscal policy is to increase aggregate demand, and its typical tools are increasing government expenditure, increasing transfers or decreasing taxes. Contractionary fiscal policy is typically attained by the opposite changes of the above budgetary items. Fiscal

policy actions will result in the shift of the IS-curve (upwards for expansionary policy and downwards for contractionary policy), and a similar shift of the aggregate demand curve AD.

Expansionary monetary policy increases aggregate demand by increasing the money supply in circulation. Contractionary monetary policy will decrease the money supply. Monetary policy affects the position of the LM-curve, expansionary measures setting higher interest rates, and contractionary measures lower ones for any level income. Figure 11.2 shows some examples of fiscal and monetary instruments.

Expansionary fiscal policy, increasing G

Contractionary fiscal policy, increasing taxes

Expansionary monetary policy, increasing the quantity of money in

circulation

Contractionary monetary policy, decreasing the quantity of money in

circulation Figure 11.2: Fiscal and Monetary Policy in the IS-LM Model

Source: Author’s own construction

When the main priority of government policy is the enhancement of economic growth, then it tries to shift the AD curve to the left applying demand side instruments. This can be done by applying either monetary or fiscal measures. However, it must take into account the various impacts of the chosen measure on the other indicators of the economy, which may be very different.

An example of expansionary fiscal policy: An increase of the value G will require higher national income at any rate of interest (and planned level of investment) to hold the balance in the goods market, therefore IS will shift upwards. The higher income increases

money demand in the money market, and initiates a movement upwards, along the LM curve.

Thus the new simultaneous equilibrium of IS-LM raises the incomes and interest rates at any P price level compared to the initial situation. Consequently, AD shifts upwards (the aggregate demand increases) and in response to that AS (the aggregate supply) starts to grow.

The higher aggreagate demand and aggregate supply sets a higher income and higher price level (top left panel of Figure 11.2).

An example of contractionary fiscal policy: An increase in taxes (T) decreases disposable income and the households’ consumption demand. Then at any interest rate (and investment demand) less income is needed for maintaining the equilibrium in the goods market, therefore IS shifts downwards. The decreasing income decreases the demand in the money market, resulting in a movement downward along LM. The new equilibrium of IS and LM will define lower interest rates and incomes at any price level P than before. Therefore AD shifts downward (aggregate demand decreases), and AS (aggregate demand) responds to it by decrease. The lower levels of aggregate demand and aggregate supply leads to lower national income, and lower price level (top right panel of Figure 11.2).

An example of expansionary monetary policy: An increase of the nominal money supply (by e.g. decreasing the refinancing interest rate or the reserve ratio) leads to the increase of real money supply M^S/P. Therefore, at any level of income and price level P the same money demand will face larger money supply, leading to a decrease in the interest rate, so any national income will be paired to a lower interest rate, and LM shifts downward (to the right). The lower interest rates will increase investment desire in the goods market, therefore demand is growing in the goods market, so the result is a downward movement along the IS curve towards lower interest rates and higher incomes. The new equilibrium of IS and LM will set lower interest rates and higher incomes at any price level P, than before. As a consequence, the AD will shift upward, and AS (aggregate demand) grows. The equilibrium of aggregate demand and aggregate supply leads to higher national income and a higher price level (bottom left panel of Figure 11.2).

An example of contractionary monetary policy: A decrease in the nominal money supply (by e.g. an increase of the refinancing interest rate or the reserve ratio) leads to the fall of real money supply M^S/P. Then, at any level of income and price level P the same money demand is compared to a smaller money supply than before, leading to a rise of the interest rate, so at any national income a higher interest rate evolves, and LM shifts upward (to the left). The higher interest rates decrease investment desire in the goods market, therefore demand is falling in the goods market, moving upward along IS, towards higher interest rates and lower incomes. The new equilibrium of IS and LM will set higher interest rates and lower incomes at any price level P, than before. Consequently, the AD will shift downward, and AS (aggregate demand) start to fall. The equilibrium of aggregate demand and aggregate supply leads to lower national income and a lower price level (bottom right panel of Figure 11.2).

The Government (State) budget is a balance containing the government’s revenues and spendings. The revenue side contains taxes collected from households and firms, the expenditure side contains transfers (grants, subsidies), and government expenditure, and government saving. The budget is balanced when the revenues and expenditures of the government are equal, no savings or deficit exist (i.e. the tax receipts are exactly equal to the sum of government expenditure and transfers). It is very rare in the real world. The government runs a budget surplus when the revenues of the budget (i.e. taxes) are higher than the sum of government expenditures and transfers, the value of government saving is positive. There are not more than one or two countries in the world that run budget surpluses.

The government runs a budget deficit when the sum of government expenditures and

transfers is higher than the tax revenues of the government, the value of government saving is negative.

Most of the countries of the world – and of the developed world – belongs to the third category. The size of the deficit is usually measured as a percentage of the annual value of GDP, the accession criteria of the Eurozone specify an upper threshold value of 3 % for this figure (Misz-Tömpe, 2006).